China continues to confound, says Ashmore’s Dehn

Jan Dehn, head of Research at Ashmore, discusses the importance of focusing on stocks rather than flow variables.

In Q3, China grew 7.8% yoy, FX reserves set a new all-time high, and the Chinese currency appreciated to the strongest level since 1993. China’s trade surplus was substantial, but smaller than last month. While markets tend to focus on flow variables – such as trade balance numbers – it is the stock variables – such as the level of FX reserves – that really matter. Stocks show that Emerging Markets (EM) are strong. By contrast, developed economies are extremely weak. Political fragilities only exacerbate the weakness.

The solid domestic demand story in China was also reflected in moderately higher than expected credit growth. The volume of new loans rose to CNY 787bn in September versus CNY 675bn expected. Broad money (M2) expanded faster than narrower money aggregates (M0 and M1), which shows that financial intermediation is increasing. The share of on-balance sheet lending rose to 56% from 45% last month. While the ratio of on and off balance sheet lending to total credit is volatile the direction of travel is consistent with the authorities’ objective of moving away from in-transparent financing of the various tiers of government.

China also released inflation data. Consumer price inflation rose to 3.1% yoy in September from 2.6% yoy in August, mostly due to weather-affected food price rises, which are unlikely to be repeated. We expect inflation to remain contained on account of deflationary impulses from the on-going restructuring of the economy and continuing FX appreciation.

Sceptics argue that narrower external surpluses are a major vulnerability in Emerging Markets. This view entirely misses the fact that many EM countries have large stocks of FX reserves, the result of many years of accumulated external surpluses in the past. These reserve cushions give EM countries the ability to manage their currencies despite a gradual reduction in external surpluses. China, more so than any other country, illustrates this fact. Sure, China’s trade surplus narrowed, but does anyone seriously doubt China’s ability to manage the value of its own currency?

Current account deficits are not necessarily a big problem for three reasons:

1) “Firstly, EM should be running deficits! Emerging Markets economies should be capital importers, not capital exporters. Capital should flow to EM because EM countries have lower capital-labour ratios than developed economies. Capital inflows would help EM to finance the investment required to sustain their economic convergence with developed economies. The gradual erosion of current account deficits is desirable, not something to be afraid of

2) “Secondly, EM current account positions should gradually decline over the next few years due to macroeconomic policies pursued by heavily indebted economies, notably the US. Inflation and currency weakness in the US will cause currency appreciation in EM regardless of whether EM likes it or not. EM countries must transition from export-led to domestic-led growth as a result

3) “Finally, current account deficits only become a problem if they cannot be financed. Global capital markets will finance EM deficits if warranted by the quality of investment opportunities in each individual EM country. EM countries are, in most cases, likely to pursue investment friendly policies for political reasons, that is, their domestic populations will continue to demand growth and stability. As this summer has shown, EM countries are generally willing to act if their external balances deteriorate for the wrong reasons, such as temporary bouts of excess domestic demand. Adjust in the so-called ‘Fragile Five’ EM countries is already having a positive effect

Global backdrop: The US debt ceiling

Congress also set itself a deadline of 13 December to report on progress towards a longer-lasting fiscal deal. The idea is that both the government funding and debt ceiling deadlines can be rendered obsolete if a broader deal can be reached. The good news is that last week’s deal reduces the risk of a near-term US default. The re-opening of government will also support the economy. But the deal struck last week is hardly the stuff of long-term solutions. In our view, the growing polarisation in US politics along increasingly ideological lines reflects the continuing weakness of the economy and the very limited choices open to policy-makers. The economy’s total debt burden is 405% of GDP, the room to change fiscal and monetary policy is very limited and Congress is completely unable to pass long-term structural reforms. Full-on money printing and the pleasant fiction that government debt is risk free are the only two band-aids holding everything together.

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